Template-Type: ReDIF-Paper 1.0
Series: Tinbergen Institute Discussion Papers
Creation-Date: 2016-02-01
Revision-Date: 2017-11-13
Number: 16-007/VI
Author-Name: Stephanie Chan
Author-Workplace-Name: University of Amsterdam, the Netherlands
Author-Name: Sweder van Wijnbergen
Author-Workplace-Name: University of Amsterdam, the Netherlands
Title: Coco Design, Risk Shifting Incentives and Capital Regulation
Abstract: Contingent convertible capital (CoCo) is a debt instrument that converts to equity or is written off  if the issuing bank fails to meet a distress threshold. The conversion increases the issuer's loss-absorption capacity, but results in wealth transfers between CoCo holders and shareholders, which may change risk-shifting incentives to shareholders. Higher risk increases the probability of CoCo conversion, while lowering the wealth transfer. We show that for Principal-Write-Down (PWD) CoCos, the net effect is to always increase risk-shifting incentives, while for equity-converting CoCos, it depends on the extent of dilution after conversion. We integrate the analysis in a game-theoretic optimal capital regulation framework and show that use of PWD or insuffciently dilutive CE CoCos requires higher capital requirements for given asset structure to offset the rising risk-shifting incentives these instruments give rise to.
Classification-JEL: G01, G13, G21, G28, G32
Keywords: Contingent Convertible Capital, Systemic Risk, Risk Shifting Incentives, Capital Requirements
File-Url: https://papers.tinbergen.nl/16007.pdf
File-Format: application/pdf
File-Size: 614924 bytes
Handle: RePEc:tin:wpaper:20160007